 Hello and welcome to the session in which we will discuss Schedule M1 on Form 1120C Corporation. What is the overall idea? What's the big idea of Schedule M1 on Form 1120? Well, here's what's going to happen. The government, they want to reconcile your gap income, your generally accepted accounting principal income to your tax income. So here's what the IRS is looking for. If you're not aware of this, we use two different sets of rules, one for gap for financial reporting and one for IRS for tax purposes. So we use two separate rules. Now what's beneficial? What will be helpful for students here if they already took intermediate accounting and specifically they took the chapter accounting for income taxes? Why? Because in that chapter, we account for the third taxed asset, the third tax liabilities. Well, the concept is the same. There are temporary or permanent differences between gap income and IRS income and gap expenses and IRS expenses. That difference in timing will need to be accounted for. So Schedule M1, it's going to show us what your income looks like from a gap perspective, what your income should look like from an IRS perspective. And what is the IRS? What's the purpose of the IRS? Well, what the IRS is looking for, there's constantly a wide difference. For example, on gap, you're constantly showing net income, large net income. And on the IRS on taxes, you're constantly showing losses or break even. Well, what's going to happen? They want to know why, why for gap, you are showing profit and for IRS purposes, you are not showing large profit. What is the IRS concerned about? They're concerned for you not paying your taxes to them. That's their concern. Are you avoiding paying taxes? So Schedule M1 will clearly show them the difference between how you reported your numbers for gap and how you are reporting your numbers for the IRS. And you will show them the difference between the two. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. So the corporation must reconcile financial accounting, financial accounting, which is gap accounting with taxable income on Schedule M1. Basically, it's a form of reconciliation between gap and taxable income, gap income and taxable income. So you always start with gap income. So we always assume that you already have your gap income. You reported your financial statements. Then you'll start to make certain adjustments. So the first thing I'm going to do, I'm going to go over few common or few common means in a sense that they are, that they are easy to understand. In common means they appear constantly on Schedule M1. Few common items to help you understand this concept. And the first item I'm going to illustrate is the concept of federal income tax per box. So when you prepare your financial statements using gap, let's assume you're looking at your income statement. We report your revenues minus your expenses minus your federal taxes. I'm going to put the taxes separately. So let's assume your revenues are $100, expenses are $60 and taxes are, for the sake of illustration, $4. So let's see. 100 minus 60 is 40 minus 6 is 36. So your net income is 36. Well, if I ask you, how about your taxable income? What will be your taxable income? If this is your gap net income, what is your taxable income? Well, here's what I'm going to say. I'm going to start with my gap income. And what I would do, I would say, hold on a second, I deducted $4 and federal taxes. This is not only any taxes, this is federal income taxes. That federal income taxes, this is an expense. Notice it's a minus, it's a deduction. For tax purposes, I cannot take this deduction. Therefore, I'm going to have to add $4 to my gap income. Therefore, my tax income is $40. So for $40, I made $40 of profit. For gap, the reason I made 36, I'm reporting 36, because I deducted $4 of federal income tax, which I cannot, obviously cannot deduct your taxes on your own taxes, your federal income taxes on your federal income tax return. So notice I deducted it for gap. To reconcile, I'm going to add it for tax. That's one example of it. Let's take a look at another example. Let's take a look at net capital losses. If you incur capital losses, what does that mean? Meaning you sold assets and you incur losses, capital losses. Well, when you report your losses for gap, let's go back to this example. Just kind of, let's go back to this example. And let's assume for gap purposes, you had $20 in capital losses, minus 20 in capital losses, minus 20. So let's take a look now at your reconciliation. $100 in revenues, minus $60, minus $4, minus 20. Now your profit for gap is 16. So this is your net income for gap. Well, that's fine. So you had $20 in capital losses and you can deduct the whole thing as far as gap concern. They don't care. They allow you to deduct all your capital losses. When it comes to the IRS, remember, you can only deduct your losses up to your capital gains. So if you have any access losses, which is here we have the 20 is access losses. The reason you are reporting capital losses because you have more losses than gains, more capital losses than gains. Well, for tax purposes, you cannot deduct these losses. Therefore, to reconcile, first we're going to add the $4 of taxes. Then we're going to add the $20 of capital losses. Now we're going to be, now we're back to $40 for tax purposes. So for tax purposes, your taxable income is $40. Okay, so this is another example of it. Also, we could have, let me just erase this now. We could have income reported for tax, but not book income. For example, prepaid income for $10,000. Let's assume someone paid you, you got paid $10,000 in cash. And for tax purposes, you debit cash for $10,000. And since you receive the money, as far as the IRS is concerned, that is revenue or income. So this is the entry that you make for tax purposes. So for tax purposes, this year you have $10,000 of income. Now, let's assume you receive this money, but you did not do the work yet. Tax don't care. If you have the money, you pay the taxes. For gap, what's going to happen is this. You are going to debit cash for $10,000 and you are going to credit unearned, unearned revenues. In other words, you have not earned this revenue yet, $10,000. So notice, for tax, you have revenue, for gap, you don't have any revenue. That's for year one. Now in year two, what's going to happen in year two? Let's assume in year two, you perform the work in year two. This will reverse in year two, you are going to have revenue for gap. So for gap, you're going to debit unearned revenue and you are going to credit revenue in year two. In year two, for tax, nothing happens because you already recorded the $10,000 in revenue. Notice what happened is in year one, you reported the revenue for tax, nothing for gap, no revenue for gap. In year two, in year two, you have revenue for gap, no revenue for tax. So what happened is as a result, there are timing differences between the two. And this is what we'll reconcile on schedule M1. Schedule M1 will show all these differences. Another example will be expenses deducted for book, but not tax. So there are certain expenses you can deduct now for book purposes, but you will deduct for tax later. What could be an example? Access to charitable contribution. When you contribute to a charity for gap purposes, you can deduct everything, all of it. It's minus. For tax, remember when we took, when we learned about charitable contribution, you are limited to 10% of taxable income. Therefore, you may not be able to deduct all of it now. You deduct all of it this year. Next year, you may not have any charitable contribution, but you have some from the prior year that you will take in year two. So you will take it in year two, but nothing in year one. Again, a difference in deduction. So this is the basic idea, but the best way to illustrate this is to look at a little bit of a numbers. Look at a complete income statement, try to reconcile the two. And then we would look at an actual schedule, schedule M1 to see how it looks like actually on schedule M1. So let's go ahead to the Excel sheet and work a quick example. Looking at this Excel sheet, we have a gap income statement. We have revenues, tax exempt interest income, life insurance, total income, 555,000, operating expenses, 450,000, access capital loss, 20,000. Premium paid for life insurance, which is an expense, 2,600, interest on tax exempt bond, 5,000. Then we paid $10,000 in federal income tax. As a result, we have a net income of 66,900. There's a purpose why I put the expenses as parentheses just to illustrate that they are being deducted. That's why they are in parentheses. That's just to make a point. Now this is your gap net income. Now you will be asked to do what? Reconcile gap income to IRS income. So let's start. Well, I'm going to start with my net income for gap, and I deducted 10,500 for federal income tax. This was an expense on my income statement, on my gap income statement, I deduct my federal income tax. Well, guess what? If you are computing your taxable income and you're starting from net income per gap because you are reconciling you're going from net income to gap to net income to the IRS, you need to make certain adjustments. One of the adjustments is you made a deduction here. You made a deduction here of 10,500. You cannot take this deduction for tax. Therefore what you do, you add back this deduction, which is bad. Adding back means what? That means you lost the deduction. You lost the deduction means your taxes are going up, your bill is going up. It means now you report more profit. If that's the only thing, then your taxable income is 76,000. Well, let's see. If that's the only reconciliation, which is not, but let me just assume that. 66,900 plus 10,000. 66,900 plus 10,500. My calculator is not working. That's equal to 77,400. If we stop here, we would say your taxable income for IRS purposes is 77,400. But that's not the only thing. But what we do is we add back. We lost the deduction. Let's go back. Since we are working with deduction, let's go back and look at interest on tax exempt bonds. What do we know about this interest? If this interest, if we incur interest and this interest is incurred to invest in tax exempt bonds of 5,000 for gap, there is no reason not to deduct this. For IRS, this amount is not deductible. Therefore, we go back and add. Again, add this 5,000 since we deducted it for gap and it's not deductible for tax. We add it back. Let's go to the excess capital loss. Remember, capital losses for gap, we can deduct as many as much capital losses as we have. For tax purposes, we can deduct capital losses up to capital gains. Any excess, we cannot do that. What do we do? We carry it over for future years. That's fine. So since we deducted it to come up to 66,900, if we are going to the IRS, we are going to add it back. Same thing for the premium paid for life insurance. We paid a premium. We paid a fee to buy life insurance. That fee for life insurance premium, as long as the proceeds are not taxable, the expense, the deduction is not taxable. Therefore, since you deducted the life insurance premium, well, guess what? You have to add it back. So what I did, all what I did is I took certain expenses, which were one, two, three, four, and I kept them separate for a reason just to kind of get you started. I took, for example, all other operating expenses here, we're going to assume this 450,000, they are deductible. This is what I'm assuming for tax as well as well as for gap. So this is what I'm assuming. That's why I listed those separately and reconciled them. What about the 450? We're assuming that those expenses are the same, whether for tax or for gap, no difference. So we took care of the deductions. Let's take it. Let's look at our revenues. Well, we have 5000 of tax exempt interest income, which is it's telling us tax exempt. Usually this is municipal bond or state bond. Well, we know from from the tax rules that interest is not taxable. So I added this 5000 and this 5000 is factored into the 66,900. Well, if I'm going to compute my taxable income, since I deducted it, now I'm going to subtract it. This is good. I like this. This is good. Why? Because I'm taken away from my taxable income. I'm reducing my taxable income by 5000. Also, if I inspect here, I have life insurance proceeds of 50,000. Again, life insurance proceeds, we know from the tax law that life insurance proceeds, just like the opposite of, you know, the premium is not deductible and the life insurance proceeds are not taxable. So therefore what I need to do, this 50,000 increased my net income by 66,900. What do I need to do? I need to deduct it, which is good from a tax perspective because it's reducing my taxable income. So those are all the items I need to reconcile. After all said and done, I reconciled my book income, my gap income, which was 66,900. After I prepared the proper reconciliation, my taxable income is 50,000. Now what I do is I go ahead and I pay my taxes. Now the IRS knows why did I report at 66,904 gap and my taxable income is lower. Mainly the largest factor is those life insurance proceeds that are not taxable, which lowered my income from my gap income from 66,900. This is mainly why I mean the others are a factor, but this is mainly why the biggest factor, the biggest factor. Now I'm going to go back to the PowerPoint slides. I'm going to put this problem on what? I'm going to put this problem on schedule M1 to show you what it looks like on schedule M1. Looking at schedule M1, this is what I have on the Excel sheet. So basically let me just, this is what we saw on the Excel sheet. This is the first part and this is the second part and we come up with taxable income. So this was gap income, this was taxable income. So let's take a look at the schedule M1 itself, which is part of Form 1120 and see what it looks like. Here's how we start. Line 1, net income per books. Net income per books we are told, let me go back, 66,900. That's net income per books. Great. Then, right under line 2, they pre-printed federal income taxes per books. Why? Because everyone will be back with their federal income tax for book purposes. Therefore, because this item is very common, because this item is very common, what they do, they'll tell you, well, you deducted it, add it back. So 10,500. Done. Access of capital losses over capital gain. Again, this is a common deduction that's taking for gap, not for tax. Therefore, they even have a pre-printed, sorry, they even have a pre-printed line and that's 20,000. Then they have a line that says income subject to tax not recorded on the books this year. You know, you could have anything here. We don't have any for the purpose of this illustration. Then we have line 5, expenses recorded on the books this year, not deducted on this return. Maybe there could be depreciation, there could be charitable contribution, travel and entertainment, or other expenses, anything, or other. Now, what expenses we took for the books, what expenses we took for the books, expenses recorded on the books, but not deducted on this return? Well, I can tell you there are two expenses that we took for the books, the premium paid life insurance and the interest exempt interest on bond. They are deducted but they are not, they are deducted on books but they cannot be deducted on the tax. Therefore, what we do is we add them back and what we do here, basically you would write premium life insurance plus interest on bonds. Just you write a description and you add them up and they add up to 7,600. Then you add line 1 through line 5 and they will add up to 105,105,000. Am I done? Not yet, I have to keep on going. Now, I'm going to look at the second side. Income recorded on the books this year, not included on the return. So, income recorded on the books, not included on the return and they have a pre-printed line for tax that they help in us. Tax exempt interest. Do I have a tax exempt interest? I sure do, 5,000. 5,000. Do you have other items? Yes, we do. Life insurance proceeds. Life insurance proceeds 50,000. 5 plus 50 is 55,000. Again, deduction on this return not charged against the books. We could have depreciation. Hold on a second. We have a depreciation here and we have depreciation here. Yes. We have charitable contribution here and we have charitable contribution here. Yes. What does that mean? It means just because you saw depreciation, it means added to one side and not the other. No, you have to be very careful. You cannot memorize what's on schedule M1. What does that mean? You have to read the information that's given to you. For example, they can tell you year one. Okay. You have makers depreciation of 100,000 and you have straight line depreciation of 70,000. So this is tax. This is gap. So for gap, for gap, you have 70,000 of depreciation expense for makers. You have 100,000. So what happened here? You have access makers. You have access makers depreciation. So when you, when you prepared your income statement, when you prepared your income statement, if there's a depreciation expense, I'm going to put a depreciation depreciation expense here and you only reported 70,000, right? You only reported 70,000. What's going to happen here? You're going to have to reduce your taxable income by and reduce. You're going to have to reduce your taxable income by 30,000 because for makers, for makers, for makers, it's 100,000. You already took 70,000 straight line. Therefore, you have to add 30,000 because it has to be 100,000 in between the two. Now the opposite could be true. For example, in year four, makers could be 70 and straight line. Now you're taking 100,000. Well, what does that mean? It means for gap purposes, you are taking a depreciation expense of 100,000. But for tax, it should be only 70. Therefore, what you do is you add, to reconcile, you will take that income and you will add 30,000 because you need to lower your deduction by 30,000. You add 30,000 of income to this number. So the net depreciation expense is 70,000. So you have to be very careful. Same thing with charitable contribution. Same thing with anything on the schedule M1. You cannot memorize the items. You can memorize certain items. It has to make sense because the way the information given to you could be very, very confusing. Now don't worry, we're going to work a few examples. But let's finish this example. So 105 minus 55 and we have nothing else here. Income for tax purposes is 50,000. Notice we went back to this. I just showed you the Excel sheet that also showed you the reconciling item. Now this is a partial list of items that could be a partial list, not a full list, on schedule M1 and it just showed you depreciation. And what do I do with depreciation? Do I add depreciation? Do I subtract depreciation? Do I add it to my taxable income? Do I deduct it? It all depends on how the information given to you. Prepaid income and prepaid expenses. It all depends on how the information is given to you, whether you need to add, whether you need to deduct. So you have to be extremely careful. How do you be extremely careful? You work examples. What do you do? I'm going to work more examples. Go to par hat lectures, look at additional examples, multiple choice, true, false. That's going to help you understand this important topic. Schedule M1 of Form 1120. This is an important, whether you are a CPA candidate, CPA exam candidate, enrolled agent or an accounting student. Good luck, study hard, and of course, stay safe.